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The effect of a corporate tax on corporate investment. The effect of depreciation allowance and the investment tax credit on corporate investment. Effective corporate tax rate.
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What happens if we introduce taxes into the story? Imagine first that the corporate tax is simply a tax at a rate t on cash earnings minus labor costs (there are no tax deductions
of any type for investment spending). The cash earnings per dollar spent on the
machine per period is MPK, so once this tax is imposed, the earnings per dollar
spent on the machine drop to MPK 3 (1 2 t) (since the new tax must be paid
on each dollar of earnings). This reduction in actual return causes the marginal
benefit curve to shift down to MB2, as shown in Figure 24-5: the taxation of corporate
earnings has reduced the marginal benefit of investing. The costs per dollar
of investment remain at d 1 r, so the marginal cost curve remains at its initial
level. The new optimal investment choice is at point B, and investment falls to K2.
Firms invest less when the government takes some of their return through
corporate taxation. This is because the firm’s after-tax actual rate of return
on the investment must be large enough to meet the required rate of return,
d 1 r. As a result, the pre-tax rate of return must be higher than it is without
taxation, and that only occurs if the firm is investing less. For example, with a
tax rate of 50%, the firm must earn $0.40 of return on a dollar of investment
to pay back its $0.20 of cost in depreciation and financing. Thus, the firm must
invest less: it should stop investing at the point where the marginal dollar of
investment has a $0.40 return rather than continuing to invest until that marginal
dollar of investment has a $0.20 return. In this scenario, corporate taxation
leads to less investment.
The Effects of Depreciation Allowances and the Investment Tax Credit
on Corporate Investment This description of the effect of taxes on corporate investment does notinclude the influence of tax deductions for investment such as depreciation allowances or investment tax credits. These tax deductions act as discounts off the price of investments, lowering the marginal cost by offsetting some of the costs of financing and depreciation.
Recall that depreciation allowances are typically spread out over the purchase
year and future years and that to value such streams of benefits we need
to consider their present discounted value (PDV). The value of any given
depreciation allowance schedule, z, is the PDV of the stream of depreciation
allowances associated with a new machine purchase, as a fraction of the purchase
price of the machine. If the firm could expense the machine (deduct
its full value in the year of purchase), z would be 1.0 because the deduction
allowance is 100% of the purchase price. As depreciation allowances are spread
out over future years, z falls because the PDV of the depreciation allowances
falls as the allowances become more distant.
Effective Corporate Tax Rate Now that we understand how taxes affect a firm’s investment decisions, we can summarize mathematically the net impact of the tax system on investment decisions. The effect of taxes is summarized by the effective corporate tax rate, the percentage increase in the rate of pretax return to capital that is necessitated by taxationThe rate of return earned by the firm on its investments must rise to finance the tax payments. How much it must rise is a function of the tax rate, the treatment of depreciation, and the presence of the ITC. These factors therefore come together to determine the overall effect of taxation on investment decisions
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2.Explain the Crowd -Out Problem in Education. How would this "solve" with the Educational Vouchers? How vouchers will lead to excessive school specialization or to Segregation?
Crowd-out problem: As the government provides more of a public good, the private sector will provide less.
Education is a public good that is provided to some extent by the private sector. As such, an important problem with the system of public education provision is that it may crowd out private education provision. Indeed, it is possible that providing a fixed amount of public education can actually lower educational attainment in society through inducing choice of lower quality public schools over higher-quality private schools
educational vouchers A fixed amount of money given by the government to families with school-age children, who can spend it at any type of school, public or private.
Vouchers might increase segregation by student skill level or motivation. As the motivated and high-skilled students flee poor-quality public schools for higher-quality private schools, the students left behind will
be in groups that are of lower motivation and skill. That is, school choice is likely to reduce segregation along some dimensions but increase it along others.
Vouchers might solve this crowd-out problem by allowing people to choose the optimal level of education for themselves, as well as interjecting competition into the education market.
At the same time, vouchers may lead to increased educational stratification, and the education market may face difficulties in implementing competition.
Existing evidence suggests that private school choice through vouchers can move students to better schools, but a much richer evaluation of the total social effects of vouchers is needed before policy conclusions can be drawn.
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